Investment Memo-2018
I received many queries from friends and family about current turmoil in stock market. Last time, when I published my analysis about Aditya Birla Capital, I promised to put next stock analysis in the blog. However, considering the widespread panic, I decided to write this memo. I find it good idea to write about performance of businesses, market situation and investment decisions. So, this tradition will be continued in years to come.
Performance of businesses discussed in the blog
Karnataka Bank : Karnataka Bank started its transformation journey by partnering with BCG. Last year of efforts of transformation were satisfactory for me. Any banking business should be analyzed from qualitative factors such as Return on Assets, Return on Equity, Net Interest Margin and Gross & Net non-performing assets. Karnataka bank is showing improvements in all of the factors except Gross and Net NPAs. I think it should take while for the bank to improve asset quality. Overall, valuations are in favor but, asset quality issues prevented me in raising stakes in Karnataka Bank. Management is on track to resolve all the issues. I didn’t sell any share.
Apollo Tyres : I sold Apollo Tyres on the day of results of Karnataka’s assembly election with 20% gain. I must admit that I have made a mistake in buying Apollo Tyres because operational performance was not satisfactory. The business which has to pray to God for passing on changes in prices of raw materials should not make a place in our portfolio. After few months I sold, issues with Corporate salary structures were reported — out of Rs. ~600 Crs of net profit almost Rs. 100 Crs were proposed to be paid to the Father-Son duo. This corporate greed when company’s performance is deteriorating is not a good sign for minority investors. You wouldn’t want to partner with such people.
Huhtamaki PPL : Overall, dual shock of demonetization and GST doesn’t go well with company. Despite, company could show moderate growth in revenues. The business has technological advantage. Additionally, they are leaders in Indian packaging sector. Recent acquisition of Ajanta Packaging, investments into new labeling machine and new manufacturing plants should augur well for this business. This quarter’s results were marred by 30Cr provisions of tax related case. I have added few more shares in this year and received dividends as well.
Bodal Chemicals : Q4FY2017–18 was not good for Bodal. This B2B textile chemicals manufacturing business has shown improved traction in demand. This commodity based business is being benefited out of China’s shutdown. Again, there are problems of price fluctuations. Promoters have bought heavily in this amid dirt cheap valuations. I don’t have lot of stake into it because of commodity business.
SPTL : This one is worthy of writing as plethora of negativity around this stock. Overall, SPTL’s management is learning from their mistakes of capital allocation. When most of working capital was locked in to Prefab business, debt on business surmounts. They have controlled the pain in the business by saying no to most of prefab orders. As a result, nearly 50% decline in prefab revenues seen. However, this step has strengthened the free cash positioning of the overall group — this is very good for debt reduction. Custom molding business is cash cow for SPTL which has around 4000Crs of net revenues and enjoys 45–50% gross margins. Management is focusing on growth of custom molding business. Their retail focus is gaining traction. Bharat 6 norms and Fortune-500 clients will do well for SPTL over the time. Overall, business fundamentals have improved since its de-merger in 2017. Insiders have bought heavily in this year by paying premium of 2.5 times the market price. Overall, when stock goes down, speculators blame corporate governance. To improve the image, they assigned one of top 4 auditors, appointed KKR’s person on board. They have reduced their short term debt till now. Another question is about growth in custom molding business. Management is focusing on improving the qualitative factors by doing ultra low capex, repaying debt, controlling cash-guzzling prefab business. Growth in the custom molding business will happen — but focusing on business fundamentals should be a priority. I bought into this and will continue to buy as management has performed.
Aditya Birla Capital : This one is famous case of regret if you overpay for any investment. ABCapital has listed at Rs. 250 — highly overvalued share. Overall, selling gripped into the market, bringing down the price to Rs. 100 or so. This is the reason valuations matter a lot — valuation is a last protection of investors mistakes. I was astonished to see that people were paying heavily for this business. Coming to business performance of ABCapital, this has competent management on board and galaxy of good quality businesses like NBFC, AMC and Insurance. While NBFC and AMC are doing very good, insurance is showing signs of further improvement.
Growth of the business is fabulous at 25–30%. India has lot scope for all these businesses as all financial services are under penetrated. Country has 21 Public sector banks, 11 of them under Preventative Corrective Action (PCA) by RBI. That means, 11 banks can’t lend but only accept deposits. Their expansion has been stopped by regulator. Some of NBFCs are paying price of over-aggression in lending. But, Indian economy is growing at 7–8%. That means, India needs access to capital. Who will grab this opportunity? Business with long-term access to patient capital like responsible NBFCs and some private sector banks.
Asset management company of ABCapital has some of top minds in the Industry. Overall, domestic flow of SIPs is growing as awareness of people is improving. Mutual Funds of ABCapital have performed well over last decade. Hence, it is grabbing one of top spot by AUM with almost 10–11% market share.
Insurance business is slowly grabbing market share and improving business fundamentals. This has potential to be next big thing.
Now, with that said, current price is a fair one considering business traction and quality. I have bought again into this and will continue to do so.
This is it from business side. At the end of 2017, my portfolio returned ~34% annualized with only 2–3 businesses viz. Karnataka Bank and Huhtamaki PPL in portfolio. Entire turmoil in stock market and some long term bets like SPTL and ABCapital, overall portfolio is in red by 15–20%. This is the pain of focused investing. Unless portfolio gets to a mark of 12–15 businesses, volatility in portfolio prevails in the short term. I believe that adding 12–15 businesses is a work of next 3–4 years. But, I will continue to hold as I believe that fundamentals of all of the businesses have improved since last year.
My approach towards investment
In brief, what makes great investment for me — Buying a business of good-to-great quality backed by competent management team, having growth potential over 10–15 years and available at reasonable valuations.
What makes a business great quality — A business which doesn’t require lot of capital to run, have pricing power, have ability to pass on changes in raw material prices to end consumer, not easy to disrupt by cheap cost operator.
What makes a management a competent one — I judge management on the basis of efficient capital allocation skills, excellent operating skills, integrity towards shareholders and focus to make the business big over long term.
What makes business to grow — I think business whose products/services customers love and reaching to masses. Another aspect is value migration from a business model to another one.
What makes business to be a durable one — products/services should not be easily disrupted by anyone. Most of my time goes into thinking about this perspective. If you choose high quality management then 80% of your worries about durability are over. A short term focused management will do anything and everything possible to break the durability of the business.
What is reasonable price —If a business is trading at discount to net present value of discounted future cash flow of next 3–5 years, it becomes a very good entry price. Valuations is the last part of equation. First, quality of business and management, durability of the earnings growth matter for long term investor.
If an investor could combine these 4 elements in a micro, small or mid sized business, then he would be better off making 2–3 decisions a year. Frankly, I run focused investment portfolio. I don’t think that over-diversification would help investor a lot. Portfolio of 15–20 businesses (which rigorously follow these 4 tenets) should do well over a period of 10 years. Not a big fan of over-diversified portfolio.
Current stock market scenario
Usually, I don’t pay heed to short-term fluctuations in the stock market. For me, stock market is another way to buy high quality investments. So, I don’t buy stocks — I buy businesses. I am agnostic towards vagaries of stock market. Stock market is filled with people with short term orientation towards returns. Trust me, you can’t build wealth in the short term. Beauty of auction driven market is that rational person can be immensely benefited if he chooses to stay away from herd.
Now, what caused turmoil in stock market in 2018 and my thoughts.
- Long Term Capital Gains Tax — Finance minister of India announced long term capital gains tax of 10% in Feb-2018. Obviously, this is not a good move for long term, high quality investors. I don’t think any investor could do anything about this decision. In next 10 years, this LTCG decision will have less impact on your investment returns.
- Mutual Fund Sell-off — SEBI rule of mutual fund caused sell off in small and midcap stocks. In last few years, valuations of small and midcap stocks were so stretched that investor’s expectations of 30%+ returns were irrational. Clearly, qualitative earnings growth of these companies was not justifying high valuations. SEBI’s rule was a needle in the swelling balloon. But, I benefited a lot from this sell-off.
- Rising crude prices and interest rates hike by RBI — Businesses using petroleum products as raw materials were hit in a Q2 of this financial year. Commodity prices and interest rates operate in cycles. Once in a while, this can happen. US Fed also raised interest rates in last few quarters. Foreign investors has taken out money from Indian markets as they get better returns in US market. No investor can do anything about it.
- Rupee depreciation — Trade war between US and China and new corporate tax laws in US caused US Dollar to strengthen. Hence, currencies of emerging markets depreciated by wide margin in very short term. This spooked the markets. However, some export oriented businesses have benefited out of this. No investor can do anything about it.
- IL&FS and NBFC liquidity woes — The house of cards institution of India, Infrastructure Leasing and Financial Service has defaulted on debt repayments in the month of Aug and Sept this year. The debts were raised by IL&FS from liquid mutual funds and banks. The asset-liability mismatch, hefty salaries to corporate leaders and declining business fundamentals of IL&FS caught market’s attentions and caused significant sell-off in the capital market, causing liquidity crunch. Some NBFC in India are dependent on liquidity in capital market. Liquidity problem in capital market hit NBFC sector. Management of NBFC who is short-term borrower and long term lender is following dangerous path. So, concern of NBFC growth instilled fear in people. Investors should be aware of high leveraged institutions. Additionally, this exposed failure of credit ratings agencies to show accurate picture of IL&FS. Govt. has appointed Mr. Uday Kotak and new board members to ease the problem.
- Indian General Election outcomes — Many people are worried whether PM Narendra Modi will be reelected or not in May 2019. As an investor, it doesn’t matter who is sitting in New Delhi. Please focus on whether the business is run by quality management.
In short, free dosage of effortless and mindless money in 2017 made people overoptimistic about Indian Stock Markets. And, they rationalized that this money making party would go on forever. You should be fearful when irrational behavior of people takes prices of assets to exorbitantly high level. Clearly, as per my analysis, fundamentals and actual prices of business differed widely. In short, all these six factors are one time and out of investor’s hand. The best can be done is — ignore these macro factors and focus on choosing great investment opportunities in this volatile market. That is only key takeaway from 2018.
How to make good investment decisions
Let me give you couple of multibagger stocks of last few years as new year will start soon.
- A stock closed at Rs. 666.26 in 1989 gave 52.92 times as of this writing — that is 14.14% CAGR in last 30 years ex-dividend.
- Second stock closed at Rs. 279.02 in Jul, 1990 returned 37.90 times as of this writing — that is 13.35 CAGR in last 29 years ex-dividend.
Can anybody guess the names of two stocks? Hold your breath — the stock no. 1 is BSE Sensex and no. 2 is Nifty 50 index. Had you invested in low cost index fund 30 years back and held it till date ignoring every volatility, market correction, TV anchor’s day-to-day commentary on market, expert’s advice — all of nonsense — you would be richer by 52 times. This is such a no-brainer, spend less than what you earn and invest surplus monthly into index fund and wake up after thirty years. Even if you start earning at the age of 30, any average person can end up having significant wealth with 30 years of working life without doing any research on business. Please note that we have not at all considered dividend incomes of these investments into calculation.
Another way to make good investment — invest in low cost, well diversified direct mutual fund of well reputed fund house. You may earn more than index fund, but key is to stay invested for long term. Here, you may get 15–20% returns.
After that, you have to make your hands dirty in analyzing businesses, management, long term durability etc to earn more than 20%. But, if you don’t have time/interest in doing so, please go for one of the way mentioned above. If you don’t do that, you will become speculator in market and will be carried away by volatility. Unless you don’t understand long term economics of business, don’t make direct stock investment. Direct investment into stocks require control over temperament, reading and conviction to hold these stocks in bad timing. Please don’t do emotional experiments with your hard earned money if you are not ready for it — go for index fund or mutual fund route. I strongly believe that your broker, TV analysts, Social media groups, chartist friends would be angry at me because idiotic ways practiced in Street will be stopped.
With that said, I wish you all very Happy New Year. Let this new year start with non-consensus views, analytical rigor and long term thinking !
Call to action
If you like the article, please share and comment your views on it. Next stock will be shared in Mar-2019. So, please stay tune.
Disclaimer
Investment in equity market is subject to market risk. Please analyze annual reports carefully. Views expressed in this article are personal. Views should not be treated as recommendations to buy or to sell stock.
Related materials
I have written other blog-posts on quality stocks. They can be found at
